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Optimists: The 20th Annual Broker/Dealers of the Year

Why Bad News Is Good News for the Independent Channel

Our Broker/Dealer of the Year survey has come of age. Twenty years of change, innovation, regulation, boom, bust (and boom again) in the independent space. And for each of those 20 years, the September issue is one to which we look especially forward. Interviews with industry thought-leaders are always revealing, but put four in a room and the interaction and information gleaned is that much more exciting. The men whose firms won Broker/Dealer of the Year honors--as chosen by their own representatives (see "How You Picked Them" sidebar)--gathered together for an entire stormy day in Chicago with Editor John Sullivan and Group Editor-in-Chief Jamie Green to answer prepared questions, but the conversation often went into unexpected and interesting directions.

This year's winners were David Stringer of Prospera Financial, Russell Diachok of Geneos Wealth Management, Eric Meyers of The Capital Financial Group/H. Beck and Eric Schwartz of Cambridge Investment Research.

With all that's happening, each had a lot to say, and editing the transcript alone took a bit of doing. But all were surprisingly candid in their views of the recruiting environment, the recently passed financial reform bill and what broker/dealers (and advisors) are doing right--and what they're doing wrong. Most important, they sound off on what needs to happen to ensure the recent market and business angst doesn't happen again.

The 20th anniversary BDOTY celebration continues online at InvestmentAdvisor.com, where readers can find the full, uncut interview transcript (an excerpt of which is provided here), individual interviews with this year's winners and behind-the-scenes video at the magazine's photo shoot. We'd also be remiss if we didn't acknowledge Commonwealth Financial Network's unprecedented 10 BDOTY wins over the years, the most of any broker/dealer. We interview founder and chairman Joe Deitch in this month's B/D Briefing about how the firm was built and what it takes to maintain such a high level of performance.

So enjoy the conversation in print and online on the present and future of the independent B/D model from the 2010 Broker/Dealers of the Year, and here's to another 20 years of challenge and growth in the independent space.

RECRUITING: IS THE WIREHOUSE EXODUS TO THE INDEPENDENT CHANNEL BEGINNING TO COOL?

Eric Schwartz, Cambridge Investment Research: Almost every broker/dealer that I've spoken with had a banner year in 2009. We certainly did. Last year we recruited $71 million of new production. The prior year was a record year at $56 million. We're going to be somewhere between $60 and $70 million this year. I would say the lead generation this year is about 30% down from last year.

What has happened is that some larger offices take longer to move. If you have 50 advisors and you're doing $12 million in business, you don't move over night. I don't think the quality [of recruited reps] has changed or the size; those are two different things to a degree. I think we do fine with most independents and I'm interested to see what other people say in the room.

Most of us don't get our recruiting from wirehouse firms, so even last year out of our $71 million I think somewhere around $9 million was from wirehouse firms. So that's only about 12 to 14%. We get a lot more from other independents that are having difficulty, which was also going on in that time period.

Eric Meyers, Capital Financial Group/H. Beck: I agree with what Eric said, especially when it comes to quality versus quantity. It's interesting; we've always had an emphasis on recruiting but we made a decision in January, February and March of 2009 to shift more of our activity and efforts to the recruiting process. While we did have a record year, and it appears this year will be unbelievable, you have to go back to take a look why. It's because so much of the momentum we initiated back in the first quarter of 2009 really hit a crescendo as we moved into 2010.

You have to take a look at your asset base and your activities and decide, for the long term, what's best for the organization. Enhancing our recruiting activities has worked out very well for us. It's continuing this year. Our best fit is still the independent rep who wants to put his clients first and be able to call senior executives in the broker/dealer to create that special relationship.

Russell Diachok, Geneos Wealth Management:Recruiting has definitely improved this year. We had a ton of activity in 2009, but I think much of it was because of the other companies that were struggling--their advisors were in a panic. The quality of people that we brought on board is dramatically up from previous years. But not so much the quantity, which I think comes from our own desire not to change the model of our firm. We don't want to be as big as Cambridge. We want to stay smaller and stay in Division II or Division III.

We've never recruited from the wirehouse world and probably never will. We don't have the resources to convert that mentality. We're getting people from smaller firms calling us and we've also had several producer groups approach us looking to be acquired. Those are the kinds of ongoing conversations that we're having.

Schwartz: A lot of firms are injured because of their exposure to these Medical Capital and similar products. So you have to analyze the prospect's exposure to those products and [determine] those that haven't blown up yet. Due diligence from our side has to be a lot higher than in the past. If somebody's sold $20 million of Med Cap he may not be in business in six months. So there's exposure where they have four clients that each have $1 million of it or even if they have 20 clients that have $22,000 each. Our due diligence teams are part of our recruiting process more than ever before.

David Stringer, Prospera Financial: One of the things we've tried hard to do is stay small because it's absolutely about quality, not quantity. We've had a strict vetting process for some time.

I like the word "like-minded" because we use like-minded in our practice. We're looking for those advisors who are like-minded in our core values; putting the client's interest first, not breaching their integrity.

We have a pretty selective process. We have a scorecard we track and obviously production and business mix is one side. But personality profile is on the other. We have a "no-jackass rule" at our firm. So our recruiting effort was big last year. We did have a number of wirehouse guys looking but they were really just tire kickers. It seemed like they were trying to get away from something instead of moving toward independence.

We did have a number of our advisors come to us from firms that had events of some kind. But big numbers for us is all relative to our scale. Our pipeline is still pretty full.

PRODUCT AND STRATEGY: WERE ALTERNATIVES REALLY ALTERNATIVES?

Meyers: For many years, up to about 1986, better than 50% of our business was in private placement and limited partnerships. We developed an expertise on the due diligence side of the equation over the years and it's kept us out of trouble. That's a big attraction to a lot of quality-oriented reps.

I do have concerns as to the [over all] increased litigation risks. Unhappy clients find it easy to go out and find attorneys who will put them in a "heads I win, tails you lose" scenario. You go back to the due diligence that you do on these vehicles; you have to be very careful as to what's suitable and what's not.

We've gone from better than 50% of our business in 1986 (and I realize that's eons ago) being private placements to now about 7%. We still have a niche in the market. We're going to keep our niche in the market. But it's interesting to note that in this particular economic contraction as compared to previous economic contractions, the private placement, limited partnership side that serves to even out the market didn't happen this time.

Diachok: Those non-correlating assets sure were correlated during this downtown.

Schwartz: What wasn't correlated were the managed futures. In the year the market was down 40%, most of the managed futures were up between 20% to 30%. And then the next year when the market went up, most of them had one of their worst years ever. So those worked.

DUE DILIGENCE: ARE YOU A JACKASS?

Stringer: As I mentioned, we had one question on our recruiting form: "Are you a jackass?"

Schwartz: Each time you make a mistake, you have to add another item to your list of questions to ask.

Meyers: It gets longer and longer.

Schwartz: We ask for mixes of business for the prior five years because "Oh yeah, I don't sell any private placement now." But they sold nothing but private placements last week; it raises a pretty big red flag.

Meyers: It occurs to me that there is a new paradigm for performance-based suitability that we have to deal with. That's part of the equation as well.

We've always had a definitive and intensive vetting process when it comes to bringing people onboard. We embrace the decentralized model, but on the other hand, you have to centralize as many of the compliance functions as possible. It's interesting.

This new bill [the Dodd-Frank reform bill] is 2,235 pages long but will probably have 4,800 pages of unintended consequences. Picture the advisor who's out there doing private placement, oil and gas deals, and has an accredited investor. He signs them up, overnights the check to us for processing and President Obama signs the law, which has a new definition of accredited investor. All of a sudden, by the time we get it the next day, it's not suitable any more. Those are the unintended consequences that are going to happen.

Stringer: And we've been living under that [fiduciary] standard for some time. When you get taken to arbitration, they hold you to a fiduciary standard anyway.

Schwartz: Obviously, regulators have been holding us to a fiduciary standard for the last 10 years, at least on the broker/dealer side. The argument is always, "You sold them the more expensive product." Well, it's still suitable, but they're saying that just because it wasn't the cheapest, therefore it wasn't a fiduciary-responsible course.

Meyers: So by selling the second best mutual fund out there, have we violated our fiduciary responsibility?

Schwartz: According to regulators, yes. And if you're selling a $2,000 IRA can you possibly do it in a fiduciary way, which requires ongoing quarterly meetings and whatever else? So they've got six months to work the definition of fiduciary. The general feeling on the Street is that they'll get an extension--[the regulators] can get extensions; we don't get extensions.

Meyers: Have you violated your fiduciary standard if you sell anything other than a no-load mutual fund? I mean these are the kinds of things we're going to be dealing with.

Schwartz: Well, certainly FSI and a whole bunch of other organizations are all over it.

EXIT PLANNING: AN ADVISOR AFTERTHOUGHT?

Meyers: The aggregate age of our producers, like the industry as a whole, is going up. One of the things we've done is initiate a program where we look for mentoring situations and then we provide financing for the sale of practices because you want to keep that business. If he sells it to someone else or he just walks away, we lose that business.

It's like everything else; you have to look not 10 yards down the line but 50 yards down the line; five, six years or longer to see what you need to do to maintain your business model.

Schwartz: Any broker/dealer that isn't getting into continuity planning better hurry up or they'll be out of business. What most advisors want to do is sell their practice to their junior partners. They don't want to sell it to some bank or some institution that's going to lose everything and aren't going to properly take care of clients.

But the problem is the junior partners don't have the money. They can't borrow from anybody because they don't have the financial strength to support the borrowing.

Stringer: It's like doing your will. Most people spend more time planning their vacation than they do their estate. We're in the process of trying to get our guys all to sign a "guardian agreement" so that, at worst case, if they don't have a succession plan or a named successor, they give us the ability to find a buyer for their practice. It allows us to find a way to get compensation to the heirs for the practice.

Being a small firm, we have enough capital so we could do a few deals and help provide a bridge of financing. I'm sure if we got to a scale where you guys are, it would be something where we have to look at it and say, "Boy, if we have a mass exodus here or a mass change of practices, we could be in trouble, so we better find another vehicle." But it is important.

Schwartz: A few years ago we had a full-time guy calling up advisors saying, "Hey, do you have a plan if you die? What's going to happen?" And 90% would say, "Not really." So we said, "Well, why don't we identify 10 people in a 50-mile radius that are a good match and maybe you guys can just have a buy-sell agreement. You can terminate it any time. But just do something so you have it and then if something better comes along, it's not a binding long-term deal."

We said, "Oh, that's pretty easy, right? There's no risk; all upside." The guy worked for six months and got one person to make the deal. The reason was that, "If you're dead and I haven't even met any of your clients, your practice is only worth six times GDC." Another guy thinks it worth 3.2 times GDC. So they don't know each other and it gets really, really complicated. So they continue doing their own thing.

Meyers: Which is nothing.

Schwartz: Right. So we moved to something similar to [Prospera], although we don't call it a guardian agreement, where we said, "Okay, we will be your succession plan."

SUPER OSJ: THE FUTURE OF THE INDEPENDENT MODEL?

Schwartz: We have a number of what we call Super OSJs. These are OSJs of 20 to 150 advisors. This is a phenomenon that didn't exist 15 years ago because they all would have been broker/dealers themselves. They tend to target reps that are somewhat smaller. It is hard to be a small broker/dealer. I think it's a lot easier to be a 2,000-rep broker/dealer than a 200 rep one right now because of the pressures of compliance and all those other things.

There's a reason that the average size of a broker/dealer is getting bigger--the cost structure is too tough. So these people say "Look I could be a broker/dealer. I'm doing my $10 million or $20 million." But I believe some of these Super OSJs will be doing $50 million and $100 million of revenue down the road. Most of them are not taking in a $50,000 or $80,000 [rep] directly, but they may take him on if he's committed to becoming a $200,000 guy and they have a program to get him there in three years. If there are five guys in [this Super-OSJ] doing $8 million between them they can figure it all out, they have the resources. With smaller-sized offices, every one of them is reinventing the wheel when it comes to an HR policy, finding an attorney to deal with their compliance, finding all the solutions to these administrative categories. The idea is we can do all that stuff a lot more cost effectively when we're doing it for 80 guys instead of one.

PRACTICE MANAGEMENT: OUTSOURCING

Schwartz: Outsourcing is another major trend that we didn't see until recently. We have people who are talking about outsourcing their staff to us, especially these young guys.

Amy Webber, who's now our president, is 41 years old and she put together a group called the New Century Counsel. It consists of advisors under age 50 but many are in the [range] of age 38 to 42. A number of interesting things have come out of that about outsourcing. Many of them said, "We just want to be able to focus on our clients. We want to be independent and prefer not to have any employees." That was one that really shocked me. Less shocking was that they want to have legal counsel, have a lawyer on staff when they have a contract to go over.

Stringer: I think as a small firm, it's not as structured as you've talked about, but we have reps who do utilize our staff for a lot of their activities. However, a lot of our reps are not comfortable giving up that level of control. They want control of their customer service experience right at the local level.

So we spend a lot of time training their sales assistants (SAs) to understand all the capabilities and technology that we offer and that they have on their desktop. The reps, like you said, want to spend their time focused on clients; they don't want to do a lot of this administrative work.

Meyers: Having been a financial advisor and running an independent office, you know that when you're looking to make a change or implement a policy, you want some counsel. You know you can put these formal coaching programs in place, but I think what they really want is the relationship with somebody who's been there before and done it--or has at least seen it across a number of different places so they can say what they've seen work and what's failed.

So what they really look for is a sounding board of best practices. As we were growing from a two-rep broker/dealer to a 50-person to a 100-person to a 1,000-rep firm, [it's been important to reps to know] I was in the field doing the exactly the same thing as all of our reps, dealing with clients, going through the same sorts of issues--I still maintain a substantial private practice on top of everything else.

I'm fortunate to have good people around me. But you have a rep pick up the phone and call you and he knows he's going to get a phone call back in 24 hours. You can sit down and talk to him because he knows you've been in the same position: That's helped our growth dramatically through the years.

Schwartz: Our largest offices are extremely interested in getting help in marketing, PR and business plans. In the past, these are things they always thought they knew more about than us. But I guess with the market conditions being a little different, almost all of them have a referral-based marketing plan. And these are offices that average $1.6 million in size.

They're very successful but what was working great for them for the last 10 years all of a sudden [has changed]: Their revenues are down 30% and they've realized that waiting for a referral is not the best plan. So we are looking at everything from teaching them how to do PR to get themselves into local media.

Stringer: We had a former reporter do a Webinar for our guys to teach them how they could get free PR in the local papers. That's a trend everybody's looking at, and a lot of people are looking for a marketing-type system. We just brought in a new group that has all these systems in place and we've got guys who are saying, "Okay, I did not realize that if I just follow this process I can find a way to get better referrals." I think you're right; everybody's looking for the answer to "How do I get my business back to where it was in 2008?" which requires new thinking.

REVENUE: A SMALLER PIE

Meyers: I think part of it is that clients are nervous about what just happened with the market and they're older. I've found if you don't have a process of risk management in place that says, "I can do it better than the Charles Schwabs of the world," you'll be in trouble.

The value-add the advisor has to bring to the party is different. They're going to have to raise their game. This is due to the fact that when you look at September 2008 through March 2009, it didn't matter what you were in, what you did or what asset allocation you had, everything went straight down. Then from March 2009 through April 2010, it didn't matter what you did and how you set it up, because you were going to do fine. The retail investor, who had just started to peek out over the top of the foxhole to look around, after the six weeks from the end of March to the beginning of July, they dove head first back into the foxholes and zipped it up with Velcro.

The worst thing you can do is jump into a foxhole with them.

But certainly there's been a reduction of wealth and, therefore, there's a smaller pie we're all sharing. I always said "up-markets are way too easy. Down markets are when we really earn our keep." No rep likes to hear their job is too easy and they're overpaid, but that's to some degree true. It's a great time to be an independent broker/dealer or an advisor. It was, relatively speaking, really easy and you made a lot of money but now it's a lot harder. I think it's going to be a lot harder for the next 10 or 15 years before it comes back.

Diachok: I think advisors are reinventing how they do businesses. The guys that were firm believers in asset allocation had it handed to them during this period of time. They're looking at ways they can be more diversified in other asset classes, and certainly the third-party money managers that we work with that are more tactical would be seeing a big influx of money moving to their platforms.

It's funny how you look at reps that you thought would be the most successful during this downturn and they're barely hanging on. I sometimes refer to our businesses as daycare centers, because the reps need psychological help right now. Keeping their heads on straight is what I spend half my time talking to these guys about. In our last big meeting there was just a ton of sharing as far as how guys are managing money and how they are doing it differently now than they did two years ago. I think hearing that from their peers is giving them the encouragement they need because they're all independent business guys and gals. It's lonely out there.

Schwartz: You asked if people have to get broader in what they offer. Not necessarily. Some are getting broader and trying to be full service, but we have other people getting worn out. All they do are 401(k)s and they're a $3 million office. They've got a niche and they're comfortable with that. It's the feeling: "Gee, I'm a million-dollar guy, but it's time for me to up my game." In some cases that's bringing in additional partners so they broaden their offering. In some cases it's focusing more on a niche. Whatever their approach, I think everybody realizes they have to up their game, whether it's one of us in this room or one of our advisors.

REGULATION: GET COMFORTABLE, THIS ONE WILL TAKE A WHILE

Meyers: The public was shocked by what happened, and politicians overact, as they always do. The Dodd-Frank Reform Bill has 4,800 pages of unintended consequences...

Schwartz: Only 4,800? There will be at least 20,000 pages of regulations that come out of that. In general we know there's going be a fiduciary standard. And, David, you were saying that you've been operating that way anyway?

Stringer: If you get into an issue with a client, they hold you to that fiduciary standard anyway. My understanding of the fiduciary piece is that when giving advice, you have to act in a fiduciary capacity. So I'm not sure how they're going to pull that off where you have a fiduciary hat on and then once you sell product you put a suitability hat on.

Schwartz: That's what they're trying to eliminate. They're trying to say you're going to have a fiduciary obligation for all that.

Stringer: I think documenting the decision-making process is something that we're going to have to address. Who knows what disclosures we're going to have to make on conflicts and potential conflicts? There are probably some point-of-sale disclosures that are going have to be implemented. I may not be seeing it as broadly as everyone else but I look at it and say, "I get it." When you're giving someone advice about their financial future, you've got to know your client. That advice should not skew towards your benefit. The problems arise when they start picking products and, as you said [Eric Meyers], "Am I violating my fiduciary standard if I don't give them the no-load and I get paid? What if I give them the second best mutual fund, have I violated my fiduciary responsibility?" The devil is always in the details.

Meyers: This series of regulatory nonsense, and I say it that way on purpose, is it's a knee-jerk reaction and it has made the pendulum swing all the way in the other direction. It's going to be years before it comes back and we could be regulated to death. You could get strangled as a part of this. That's the unfortunate reality we're going to have to deal with.

When you have a compliance department that grows from five or six people to 35 people in a two-year period, something's wrong. There's got to be some balance there.

Diachok: We've been through that over the last 10 years. If there's one piece of our firm that's much bigger now than it was 10 or even five years ago it's the compliance department.

Schwartz: Compliance is a bull market. There's a good career choice!

Diachok: Plain and simple.

Schwartz: In our broker/dealer, as in many, most of our advisors do both fee and commission business. In our case, 60% of our revenue is fee-based. So that 60% have been held to a fiduciary standard already. But if you ask a single one of them what they do different for their fee-based clients than for commission-based clients, they would say nothing. "Oh, okay, now I've got this client I'm going to screw while I treat this one differently!" They treat them all the same. They don't distinguish between the two. They hold themselves to the same standard already. So there may be different paperwork we have to sign and something may change. We may not be able to do "X" and we may not be able to do "Y" but I think most advisors at most broker/dealers of our type are still in the advice business and they're holding themselves to what they deem as the fiduciary standard today.

Meyers: Remember FINRA audits just a couple years ago? Two people came in and they spent a week or two. Your last FINRA audit, how many people came in and how long did they stay?

Diachok: Three people, three weeks.

Stringer: It was three people; it may have been three or four weeks.

Schwartz: Our team's a little bit bigger. I think they had four people for three or so weeks, but they keep asking for follow-up information. No one wants to stay in Iowa [Cambridge's home state], so they go home and then they ask us for the information.

Meyers: You know what it is? We're the largest broker/dealer in their particular district and so they thought they had to pay more attention. And on-site time is not the end of the audit.

Schwartz: Of course not. They leave and "hello!" the SEC comes in. And it's all fine. There are no problems, but the time it takes gets to the point of absurdity. I don't think broker/dealers are going to have a hard time satisfying the fiduciary rules once they figure out what they are.

Stringer: Especially in the independent space because we don't manufacture product. I think there's an inherent conflict when you're making product and distributing it, versus when you have an open architecture and you say, "Let's put the best products on the platform and let the advisor choose." But when we don't manufacture and the firm is not steering the client towards the Prospera Mutual Fund we eliminate that conflict in the independent space.

Diachok: It's not hard to hold yourself to a fiduciary standard. It's just figuring out what the fiduciary standard is that regulators want to see.

Meyers: And then how do you document it?

Diachok: For the firms that don't have good automation, it's going be a real challenge for them to survive the increased proof of suitability documentation at the audit level every year. We're doing it already and I'm guessing probably all the firms here are.

Schwartz: I think most of our advisors are positive toward other aspects of financial reform legislation because they see their clients being abused by these big firms. More regulation on huge hedge funds, and derivatives in particular, means no direct effect to our advisors. And really, most of them aren't paying attention to it and neither are we. I think there probably aren't too many people who feel sorry for hedge fund managers and the derivatives departments at Morgan Stanley.

It's hard to imagine the people that managed all that money and created all these problems have virtually no regulation while we are highly regulated. So I think there's a general feeling that we're comfortable with it, but probably none of us have studied it to see if it's really going to work.

Meyers: But the impact to the markets is a big fuzzy spot.

Schwartz: Considering all our other problems, none of us is paying attention to those things that don't affect us directly. But one of the other initiatives that is directly related to us is sending the RIAs that have less than $100 million in AUM back to the states. This one is interesting. RIAs with less than $100 million in AUM represent something like 0.4% of the total assets under management in RIAs. So you realize they're not talking about the kind of RIAs we're talking about: They're talking about American Funds that has an RIA that manages $300 billion or something like that; that's a whole different segment.

Their attitude was "Hey, it's only $80 million. If they steal all that it's no big deal. Let the states deal with it." But some of the states are bankrupt and they don't have the money to supervise. And when you consider that the average RIA was audited once every nine years and 25% have never been audited, I don't know if the state could do any worse of a job than the federal government.